The data suggest, yes almost all are. But there’s another interpretation, mainly, that people mistakenly apply a rule of thumb (higher risk-higher return) to areas where it doesn’t, and can’t, hold. Let me explain.
Private Equity Underperforms Public Equity? What is Private Equity?
A commenter on the Opening Bell this morning linked to an FT article suggesting that private equity actually (surprise suprise) underperforms major public equity benchmarks, like the S&P 500. We're a bit skeptical of most data that tries to aggregate...
Well, its a rather inchoate concept in my head, but basically, a non-zero-sum game is where you create rights. When you buy a stock and some warrants that are already trading, you are in a zero-sum game, because you are merely buying what already existed and was priced fairly (on average). So buying listed securities, or passively buying someone's hot dog stand, are all zero-sum. Buying unlisted securities and negotiating rights to buy more at a fixed price, buying a hot-dog stand but then deciding to sell lemonade as well, that's non-zero sum. So the extra value can come from expropriation (demanding rights and warrants that dilute existing claim holders--usually because they are desperate) or value creation (providing complimentary services). The key is, you need a lot of capital to be able to demand rights and warrants, so for most investors that's not feasible. As per providing value no one thought of for existing small operations, that's more feasible, but again, it's nontrivial in terms of resources or effort.
The second answer, the proof I can't fit in the margins of this blog post (heh), is that risk taking as a general strategy does generate above average returns, but only in domains that are not zero sum.
Could you clarify what you mean by "domains that are not zero-sum"? If I'm providing an insurance service, is this a "zero-sum domain"?
Risk-taking should generate excess return unless the risk can be diversified away: clearly this isn't the case for private-equity placements and other non-standard investments.
Real estate investment is one domain which is arguably "zero sum" and hard to diversify for most people - at least until recently. Historically, it seems that those investors who were wealthy enough to diversify their investment could earn excess returns.
First, as to Goetzmann and Kumar noting only 3 stocks, these were for equity portfolios that seemed to exclude funds. They noted that something like $9k was the average individual mutual fund, and $13k was the average individual equity portfolio. So the equity volatility was in that context, making things tricky.
As to 15 stocks being sufficient, I think that's if things are stable and gaussian. In practice, 15 isn't nearly enough because when it really matters--downturns--correlations rise predictably, so an average correlation of 0.12 based on daily vols is probably off by a factor of two. I find, personally as a portfolio manager, that 100 is necessary to get 'asymptotic' volatility for any one country (ie, comparable vol to an index), and that assumes you are not loaded in one industry or some factor (eg, momentum).
The statement that well diversified portfolios according to mean-variance optimization consists of hundreds of stocks (besides some portion invested in the riskfree rate) is wrong i guess, its explained by the law of diminishing returns. Most portfolios of professional investors and fund managers only have like 10 or 15 stocks in them and still being on the efficient frontier (Markowitz).
This may seem off topic but in order to meaningfully participate I would like to know what "overcoming bias" is about, I mean WHICH bias?In other words how do you define an truly circumscribe the "no-bias" condition?Because if you can't all this is just another fluffy "philosophical" smalltalk.
You wrote, "As opposed to owning hundreds of stocks, Goetzmann and Kumar (2001) and Polkovnichenko (2004) found the median number about three, not much different than what the Fed reported from a 1967 survey."
This is so far from what I would have guessed, I don't even know what to say. I would have guessed that a huge fraction of those who own stock own it by way of mutual funds in qualified plans -- hundreds of stocks.
The use of online brokerage accounts as a data set in the Geotzmann study may be skewing this result downward. It's not clear from the abstract where the other study pulled the data. Still, a surprising fact.
I actually deviate from the traditional mean-variance utility function in the linked paper on Risk and Return, but in general try to stay in this constraint. If you are suggesting mean-variance-"x" preferences, where people like/dislike some attribute "x" when investing, it would be interesting to document such a characteristic, and then target it, either by marketing to retail that "you won't pay for our lame attempts to confabulate" or to institutions (e.g.,"short stocks that go green")
Does financial return explain investor behavior, though? It sounds like your unstated premise is that investors are trying to maximize their Sharpe ratio -- I think it makes more sense to realize that they're also maximizing their psychological well-being.
Private Equity Underperforms Public Equity? What is Private Equity?
A commenter on the Opening Bell this morning linked to an FT article suggesting that private equity actually (surprise suprise) underperforms major public equity benchmarks, like the S&P 500. We're a bit skeptical of most data that tries to aggregate...
Well, its a rather inchoate concept in my head, but basically, a non-zero-sum game is where you create rights. When you buy a stock and some warrants that are already trading, you are in a zero-sum game, because you are merely buying what already existed and was priced fairly (on average). So buying listed securities, or passively buying someone's hot dog stand, are all zero-sum. Buying unlisted securities and negotiating rights to buy more at a fixed price, buying a hot-dog stand but then deciding to sell lemonade as well, that's non-zero sum. So the extra value can come from expropriation (demanding rights and warrants that dilute existing claim holders--usually because they are desperate) or value creation (providing complimentary services). The key is, you need a lot of capital to be able to demand rights and warrants, so for most investors that's not feasible. As per providing value no one thought of for existing small operations, that's more feasible, but again, it's nontrivial in terms of resources or effort.
The second answer, the proof I can't fit in the margins of this blog post (heh), is that risk taking as a general strategy does generate above average returns, but only in domains that are not zero sum.
Could you clarify what you mean by "domains that are not zero-sum"? If I'm providing an insurance service, is this a "zero-sum domain"?
Risk-taking should generate excess return unless the risk can be diversified away: clearly this isn't the case for private-equity placements and other non-standard investments.
Real estate investment is one domain which is arguably "zero sum" and hard to diversify for most people - at least until recently. Historically, it seems that those investors who were wealthy enough to diversify their investment could earn excess returns.
First, as to Goetzmann and Kumar noting only 3 stocks, these were for equity portfolios that seemed to exclude funds. They noted that something like $9k was the average individual mutual fund, and $13k was the average individual equity portfolio. So the equity volatility was in that context, making things tricky.
As to 15 stocks being sufficient, I think that's if things are stable and gaussian. In practice, 15 isn't nearly enough because when it really matters--downturns--correlations rise predictably, so an average correlation of 0.12 based on daily vols is probably off by a factor of two. I find, personally as a portfolio manager, that 100 is necessary to get 'asymptotic' volatility for any one country (ie, comparable vol to an index), and that assumes you are not loaded in one industry or some factor (eg, momentum).
The statement that well diversified portfolios according to mean-variance optimization consists of hundreds of stocks (besides some portion invested in the riskfree rate) is wrong i guess, its explained by the law of diminishing returns. Most portfolios of professional investors and fund managers only have like 10 or 15 stocks in them and still being on the efficient frontier (Markowitz).
This may seem off topic but in order to meaningfully participate I would like to know what "overcoming bias" is about, I mean WHICH bias?In other words how do you define an truly circumscribe the "no-bias" condition?Because if you can't all this is just another fluffy "philosophical" smalltalk.
Thanks for this post.
You wrote, "As opposed to owning hundreds of stocks, Goetzmann and Kumar (2001) and Polkovnichenko (2004) found the median number about three, not much different than what the Fed reported from a 1967 survey."
This is so far from what I would have guessed, I don't even know what to say. I would have guessed that a huge fraction of those who own stock own it by way of mutual funds in qualified plans -- hundreds of stocks.
The use of online brokerage accounts as a data set in the Geotzmann study may be skewing this result downward. It's not clear from the abstract where the other study pulled the data. Still, a surprising fact.
I actually deviate from the traditional mean-variance utility function in the linked paper on Risk and Return, but in general try to stay in this constraint. If you are suggesting mean-variance-"x" preferences, where people like/dislike some attribute "x" when investing, it would be interesting to document such a characteristic, and then target it, either by marketing to retail that "you won't pay for our lame attempts to confabulate" or to institutions (e.g.,"short stocks that go green")
Does financial return explain investor behavior, though? It sounds like your unstated premise is that investors are trying to maximize their Sharpe ratio -- I think it makes more sense to realize that they're also maximizing their psychological well-being.